Asset Weighted Returns…an ignored concept

Around a year ago I was involved in a project looking at life cycle investing and I flippantly said that we should differentiate in the market place by offering the younger investors, say 25 years of age, 150% geared investment that reduces down to 30-40% risky assets at age 65. Older investors could lend to the younger investors, at say 7%pa, and it was win-win….that is, the older investor would receive above-market yields for their fixed interest investment and the younger investors had cheap borrowing.

Of course, I’m sure you are all thinking that I was being a little stupid naive in that I wasn’t considering what happens in case of a market crash…obviously, the younger investors would be in default and the older investors had a fixed interest investment that has failed. A terrible strategy? Do you think?

Here’s an oversimplified scenario. If my 25 y/o has a balance of $10,000 and borrows $15,000 (i.e. 150% gearing), and this total of $25,000 is invested in a diversified equities portfolio which crashes, say worse than 2008, and loses 50%…the outcome is that the portfolio is now worth $12,500 with a loan of $16,050 ($15,000 + 1 year’s interest @7%)…hence the value is negative $3,550…obviously a negative balance isn’t that good. But you know what, if the 25 y/o is earning $25,000, then in a little more than 18 months that negatiev balance will be paid off by SG contributions of 9% and the 27 y/o is back to square one with another 38 years to save for retirement. Whilst the result is not good…it is far from recoverable in terms of providing for retirement.

What we have today, is an enormous number of pre-retirees invested in balanced funds that have around 70% of risky assets. If a pre-retiree, say age 64, had saved $500,000 to the end of 2007, and was ready to retire at the end of 2008, they would have started retirement with a balance of $400,000 at best. Recovering $100,000 in retirement is impossible and it takes an incredible massive income to save $100,000 over a few years…now this situation is a disaster.

What these two examples demonstrate is the power of asset weighted returns. The financial services industry is so caught up in a “time-weighted” returns, i.e. looking at average returns over the last 5, 10, 30 years that it does not consider the impact returns have on the ‘size’ of one’s assets.

So whilst everyone thought my 150% gearing was outlandish, is it really as outlandish as the appalling practice we see today where an enormous number of pre-retirees are investing in “balanced funds”? No where near it…my 25 year old can easily recover but the pre-retiree with the so-called ‘lower’ risk strategy cannot.

Professor Michael Drew of Griffith University and QIC has been talking about asset weighted returns for some time now…I can only hope the financial services industry starts to listen and adjusts accordingly.